Friday, April 24, 2009

Bill Moyers had another great show on the financial crisis tonight. The show unified many of the concepts I have written about in recent months. The discussion raises many important questions, perhaps none more important than whether the Obama administration will have the courage to support the newly-proposed Congressional panel that will investigate the crisis and propose reforms. Please watch.

Bill Moyers speaks with economist Simon Johnson and Ferdinand Pecora biographer and legal scholar Michael Perino. Johnson is a former chief economist of the International Monetary Fund (IMF) and a professor at MIT Sloan School of Management, and Perino is a professor of law at St. John's University and has been an advisor to the Securities and Exchange Commission.

To qualify for bailout funds, Goldman's application to convert to a bank holding company is expedited, even though it doesn't engage in any common banking activities. (Have you ever seen a Goldman Sachs ATM, credit card, or TV commercial?)

Their former CEO, then-Treasury Secretary Hank Paulson, gives them $10 billion of TARP money...well, they are a bank now, after all.

News surfaces that Goldman had been hedging its exposure to losses in mortgage securities by buying credit default swaps from AIG. (Oh, so you mean they have insurance to cover their losses? Why didn't they tell us that before we gave them the TARP money?)

The Fed and Treasury think a calamity will ensue if AIG fails and its counterparties, like Goldman, are not paid off. So, an additional $80 billion of taxpayer money is given to AIG, who promptly pays off its counterparties, including several foreign banks. Goldman Sachs gets $13.9 billion. (But wait! Didn't we already cover Goldman's losses with TARP money?)

Goldman loves the volatility in the markets--it makes for great trading--and racks up $5.7 billion in trading revenues in the first three months of this year. In short, they're right back to doing the same things that got them into trouble in the first place.

Goldman says it doesn't like that the TARP funds came with strings attached, so they want to pay the money back early. Things are going pretty well for them these days, so they sell $5 billion in stock to raise additional money to pay back the TARP funds.

Happy days are here again!

I would like for Obama to ask his people how the public was supposed to be helped by providing Goldman with the risk capital to run its trading desk. TARP money was intended to fund loans to businesses and consumers, not high-risk trading operations.

Bill Black, a former senior bank regulator and S&L prosecutor, is one of the few people with both the guts and knowledge to speak the truth about how the banking crisis is being mishandled, and principally by the people who caused it in the first place. When all we get is spin from Larry Summers and Tim Geithner, it's reassuring that at least one strong, reasoned voice is willing to speak the truth.

From the article that accompanied the video:

The bank stress tests currently underway are “a complete sham,” says WilliamBlack, a former senior bank regulator and S&L prosecutor, and currently anAssociate Professor of Economics and Law at the University of Missouri - KansasCity. “It’s a Potemkin model. Built to fool people.” Like many others, Blackbelieves the “worst case scenario” used in the stress test don’t go far enough.

He detailed these and related concerns in a recent interview with NakedCapitalism. But Black, who was counsel to the Federal Home Loan Bank Boardduring the S&L Crisis, says the program's failings go way beyond suchtechnical issues. “There is no real purpose [of the stress test] other than tofool us. To make us chumps,” Black says. Noting policymakers have long statedthe problem is a lack of confidence, Black says Treasury Secretary Tim Geithneris now essentially saying: “’If we lie and they believe us, all will be well.’It’s Orwellian."

The former regulator is extremely critical of Geithner,calling him a “failed regulator” now “adding to failed policy” by not allowing“banks that really need desperately to be closed” to fail. (On Saturday,Geithner said on Face the Nation, if banks need "exceptional assistance" in thefuture "then we'll make sure that assistance comes with conditions," includingpotentially changing management and the board, but did not say they'd be shutdown.)

Black says the stress test must also be viewed in the context ofGeithner’s toxic debt plan, which he calls “an enormous taxpayer subsidy forpeople who caused the problem.” The fact bank stocks have been rising sinceGeithner unveiled his plan is “bad news for taxpayers,” he says. “It’s thesubsidy of all history."

I love this! From the article's author on Larry Summers and "brain bubbles":

"This is the process wherein the intelligence of an inarguably intelligent person is inflated and valued beyond all reason, creating a dangerous accumulation of unhedged risk. Brain Bubbles need to be popped; Larry Summers needs to be stopped!"

Monday, April 13, 2009

I have a real bee in my bonnet these days about Goldman Sachs. Yes, they are good at what they do, and technically speaking, I can’t say that I’m aware of them having done anything illegal during the buildup to our current crisis. However, in my book, they are the poster child for all that should be purged from the financial markets. Having Goldman running amok in our financial system is like having wild pigs in your back yard. No one really dislikes wild pigs, but there's absolutely no upside to having them in your back yard. Even worse, they can do a fair amount of damage. Ditto for having Goldman in our financial system.

Goldman’s bread and butter is trading and investment banking, the latter of which is on hiatus for who knows how long. So, its shareholders essentially just own an interest in a big trading desk. Goldman takes shareholder capital and speculatively trades in stocks, options, bonds, foreign currencies, interest rates, credit default swaps, etc. Name a derivative, and they probably trade it. As I said, it’s all speculative. They do nothing to create value. They just trade. However, what they do is different from just going to Vegas and rolling the dice. How so? Because their very act of placing a bet can actually have an influence on the outcome of that bet; for example, when they choose to short a stock. They can relentlessly drive a stock into the ground, and those on the losing side of the trade are the public, who were lulled into believing that buy-and-hold is a viable investment strategy, and that the SEC is ready and able to protect their interests.

I’d like someone in government who is allowing this to happen to explain why it’s in the public’s interest to let Goldman ride roughshod over the financial markets. How do we benefit? Clearly, we don’t, and that’s precisely why the realm in which Goldman plays—what some people call the shadow market—needs to be regulated into oblivion. Simply put, we need to purge the financial system of the casino activities that have done so much harm in recent years, and we need to make an example of Goldman, precisely because it is the much-envied “gold standard” among firms that engage in these activities. The financial markets need to be returned to long-term investors, and made safe with rules that are clear and enforced.

It is a tragedy that the public has been denied the right to participate in the capitalist system without it being corrupted and manipulated. Investors with good intentions have been completely thwarted by the likes of Goldman and countless other hedge funds and institutional trading desks for too many years now. Enough is enough. The stock market wasn’t created with the intention of using the public as pawns in trading schemes that only benefit the rich. Goldman and other market manipulators must be shown the door if we are to ever restore trust in the financial markets.

Saturday, April 11, 2009

Someone on another blog, SeekingAlpha, wrote an article in which he asked, "Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage?"

The answer is actually quite simple: leverage. Leverage creates losses that are multiples of the original amount of capital that was put at risk. In short, people borrow to buy assets that end up losing tremendous value, and then those people are left with the debt and no assets to sell to cover it. For example, low margin requirements amplified the losses associated with the 1929 crash, making the fallout much more severe than the typical market correction. Investors were required to put up only 10% of the cost of the stock when they purchased it. When the stocks lost most of their value, the investors still owed a remaining 90% of the original cost. Where was that money going to come from? Certainly not from selling the stock. So, the stock investors of 1929 defaulted on their margin debt and left the banks holding the bag. This is the same situation today, except that we're talking about inflated home values and defaulted mortgage debt.

Complicating the mortgage default problem is the destruction caused by the casino-like activities in the unregulated credit default swaps market. The likes of Goldman Sachs put up pennies on the dollar to buy swaps (again, the use of leverage), most notoriously from AIG, and left AIG with losses of 30-50 times of what Goldman paid. Because our brainiacs in Washington decided to bail AIG out, the public will now be paying for those losses for decades, thus putting a stranglehold on the economy for years.

Most economic crises have not involved substantial leverage. The dot-com crisis is a good example. Trillions were lost in that crisis on dot-com stocks, but those stocks had not been purchased with leverage. Money was transferred from one party to another, but there was no change in the amount of money in circulation within the economy. In other words, although the dot-com stocks took a beating, the economy as a whole was net neutral. Hence, the recovery was fairly swift, given the magnitude of the disaster.

Today, in contrast, we borrowed to create inflated asset values. Indeed, the credit amplified the inflation, as buyers who weren't required to put cash on the table became desensitized to the prices they were paying. Those assets have now declined in value by half, but the debt remains. Hence, the economy as a whole is in a net loss position (technically speaking, insolvent), whereas it wasn't following dot-com mania. It is much more difficult to recover from such losses.

Our government is borrowing money to pay off the debts that are left over from the housing bubble, thus socializing the losses from the housing market and Wall Street's excesses. However, replacing one debt with another debt does nothing to get the economy out of its net loss position. Only the generation of profits and the systematic and disciplined repayment of debt from those profits can do that.

Saturday, April 4, 2009

Some of my friends have asked me how the current crisis differs from the dot-com meltdown and the recession that followed it. They asked, with a hopeful inflection, "Weren’t trillions of dollars lost in that whole debacle, and even though that recession was really bad, didn’t we get over it pretty quickly?"

Yes, it was an obscene, huge disaster. Trillions were lost, and like today’s crisis, it was the result of a massive, irresponsible bubble. Of further similarity, the damage was initially confined to one economic sector (tech then, and home lending this time), but the fallout subsequently spread over the next year or two to the rest of the economy, resulting in a widespread and deep recession. Importantly, we did recover from that recession fairly quickly, especially when you consider that the recession was exacerbated by an event, namely 9/11, that obviously had no connection whatsoever to the dot-com meltdown. That said, to be fair, it is also important to remember that the recovery from that earlier recession was made possible at least in part by the credit-fueled bubble that we’re currently suffering from.

So, will the recovery from this recession also be quick? If not, what’s different this time?

My feeling is that the current government-sponsored stimuli will lead to the appearance of recovery for a time, but it won’t be sustainable. Why? Because all true recoveries are born from the failure of the weak, and the redeployment of sidelined assets (including human assets) in the creation of new goods and services that consumers really need and want by viable businesses with the know-how to cost-effectively leverage those assets. In other words, financial capital (whether it comes from investors or taxpayers) must be deployed in ways that will generate true demand in order for economic activities to be sustainable. Government-sponsored spending initiatives don’t do that. Why? If they were viable, sensible investment opportunities, investment capital would have already found its way to them.

In the dot-com meltdown, the likes of Webvan, Pets.com, and Kozmo.com were allowed to fail. Shareholders and bondholders lost billions, but there were no bailouts. Their business models were flawed from the get-go, and there simply was not enough demand for their services to make them viable long term. Death was a fitting and proper solution, and the hordes of tech workers who had been wasting their time creating animations of gerbils jumping through flaming hoops were provided an opportunity to move on to the likes of Apple, Cisco, Google, Salesforce.com, and countless other enterprises old and new to create new products and services. Had the government propped up Webvan with billions of dollars to build additional unneeded warehouses, where would we be today? Of course, there was that painful couple of years in which businesses and consumers hunkered down, cut costs, rebuilt their financial strength, and regrouped strategically. That was no fun, but the healthy emerged from that period stronger, leaner, and more focused on providing true value to the consumer.

Today, unfortunately, we refuse to take the pain and we are propping up the weak, afraid to face reality. Insidiously, those who have been in bed with Wall Street for years have been put in charge of cleaning it up, so no real progress will be made until all personal favors are repaid and the players move on to their vacation homes on Long Island. So, rather than promoting failure and a healthy redeployment of assets to capable stewards of those assets, we are left with zombie corporations that will need, in Treasury Secretary Geithner’s judgment, $2 trillion of additional funding to survive. (Geithner is one of the bad guys, by the way.) In the meantime, while we’re trying to resuscitate those zombies, we plan to spend trillions more on bridges to nowhere (i.e., “shovel ready projects”) and other social programs that are destined to become anchors around taxpayers’ necks, as our politicians will surely find ways to turn temporary stimuli into permanent entitlement programs. When all is said and done, we’ll be no better off. Our economic engines will not be refueled, the corrupt and incapable will still be in charge, the casino mentality responsible for this mess will be allowed to return (if not facilitated outright), and we’ll be saddled with $10 trillion more in national debt, with no obvious benefits from its expenditure. Hence, these are the reasons why the recovery will not be sustainable.

Capital is precious, and it must be used in ways that will provide returns. Life support for zombie corporations, bridges to nowhere, and high speed trains to Las Vegas don’t provide a return on investment. Like information, ideas, and humanity itself, capital needs to be free to find its proper place. It needs a home where it can prosper and multiply. Ineffectively deployed capital needs to be allowed to move to a new home, as it did following dot-com mania, the S&L crisis, the “Asian Contagion” currency and credit crisis of the ‘90s, the oil patch meltdown of the early ‘80s, the foreign lending crisis of the late ‘80s that almost took BofA down, and the LBO junk bond boom-bust of the ‘80s. (See, there’s really nothing unusual about crises. We have them all the time!) All of those crises were considered devastating at the time, but they ultimately had no long term ill effects. On the other hand, the current blueprint for recovery was tried in the U.S. in the ‘30s and in Japan in the ‘80s-‘90s, and the outcomes then, respectively, were the Great Depression and the “Lost Decade.” I wouldn’t call that a blueprint for success.

U.S. National Debt Clock

About Me

Pat has nearly 30 years of experience as a financial executive. He is a CPA and holds an MBA from MIT's Sloan School of Management, where he was a Sloan Fellow. Pat's research interests include investments, financial markets, leadership and ethics, innovation and business sustainability, I.T. strategy, corporate governance, economics, politics, and globalization.